Last week, we ran highlights from NACD’s most recent Leading Minds of Governance program, where a panel of highly experienced governance experts and directors spoke on the board’s role in overseeing corporate culture—and crises that arise from failures in corporate culture. In our continuing coverage of that event, Cathy Halligan, a director of FLIR Systems and Ultra Beauty, and Tara Tays, managing director at Deloitte, discuss the issues of say on pay—and the ways in which executive compensation can attract top talent while also attracting unwanted attention from proxy advisory firms.

Cathy Halligan (r.) addresses the panel, including Christopher Cernich (l.)

The issues of say on pay and talent retention are top concerns for many boards. How can a compensation committee strike the right balance between garnering shareholder support for the compensation package and incenting and retaining a high-performing CEO?

Halligan: I advise compensation committees and boards to start with the philosophy that a consistently performing CEO is not always easy to have, and a high performing CEO is rarer and can be difficult to retain because she or he is in great demand. In an environment where one has a consistently performing or high-performing CEO, keep that in mind first and foremost when considering compensation. In terms of the balance between a compelling retentive CEO pay package, relative to the scope and complexity of one’s business, and any potential governance agency issues, my advice is to err on the side of delivering a compelling compensation package to a performing CEO. Leave the ISS [Institutional Shareholder Services] and Glass Lewis narrative to the side while thinking through compensation. Then, explain to investors the rationale behind the CEO compensation, drawing linkages to performance.

Aligning compensation with shareholder value creation is most important. In my view, nothing aligns more purely with the shareholder than including stock options as a long-term retentive vehicle in long-term incentive or special retention grants. That being said, ISS and Glass Lewis do not view stock options as performance-based compensation, which is a real head-scratcher for me. In a Glass Lewis or ISS report on CEO pay, the entire value of a stock option grant is priced in the compensation table on the day in which it’s granted. Even if the vesting schedule is out six years, and doesn’t even start vesting for two years. There’s a disconnect between demonstrated retentive compensation and recording the positions by ISS and Glass Lewis.

One last point I would make is that Glass Lewis and ISS do not like special grants given to CEOs in addition to long-term incentives as part of an executive compensation program. Their rationale is that if the executive compensation program in and of itself isn’t correct, and there’s a need for an additional grant, the board should take a harder look at the executive compensation program. While that might be true in some situations, it is not accurate across the board. Consider Ulta Beauty. CEO Mary Dillon drove incredible performance, and the stock has outperformed the market by a wide margin since July 2013 when she became CEO. While the executive compensation program had achieved all of the criteria that the compensation committee had set out, given the exceptionally good performance of our CEO and our interest to protect the shareholders and retain her, we did issue a special stock option grant that had pure retentive hooks. It was a six-year vesting schedule that started vesting in year two, so clearly long-term. ISS and Glass Lewis both issued quite unfavorable reports, but it was the right thing to do for Ulta shareholders to retain a very high-performing CEO with an instrument that was completely aligned with the shareholder. In summary, do right by a high performing CEO, and then talk to your investors.

Tara Tays

ISS and Glass Lewis always seem to garner a moan from directors when they’re brought up. It’s important to understand their guidelines, but are the proxy advisory firms’ preferred compensation policies sound, and are they truly in shareholders’ best interests?

Tays: The proxy advisory firms’ executive compensation guidelines are meant to help shareholders think about how to vote on a say-on-pay’ proposal, and while the methodology used by these firms over the past seven years has been refined and now lead to many tests that guide shareholders on whether to vote “for” or “against” this type of proposal, the guidelines don’t always provide shareholders a holistic picture on all criteria that should be considered when determining how to vote on say on pay.

Generally, there is one reason why proxy advisory firms will vote against a company’s say-on-pay proposal, there is significant misalignment between CEO pay and company performance. One proxy advisory firm will also consider NEO [non-executive officer] pay and company performance. Other factors that will be taken into account by the proxy advisory firms include whether the company has problematic pay practices, e.g., egregious one-time payments, single trigger change-in-control provision, excise tax gross ups, etc.; and whether the board displays poor levels of communication to shareholders.

While the proxy advisory firms’ tests measure the size of a CEO’s pay package in comparison to total shareholder return and financial performance, they don’t measure a CEO’s realizable pay—the same is true for NEOs. And one might question whether a pay for performance model built on grant date long-term incentive value really provides an informed picture on the relationship between pay and performance. Now, total compensation granted to a CEO in one year is important, however, it is just as important to understand what the CEO earned in base salary, bonus and the value of equity actually earned over a period of time.

Why is this important? At the end of the day, if the company’s stock is not performing, the value originally granted to the CEO is simply the equity value at grant date and maintaining that equity value is heavily dependent on the future financial or operational success of the company.

Also, more and more CEOs are granted long-term performance-based awards and the actual equity earned (or settled) is usually determined two, three or four years later. Therefore, a CEO’s realizable pay over a period of time is just as important as the pay level delivered in a year and combining the two analyses together paints a clearer picture for shareholders on whether there is alignment between pay and performance.

It is also important for proxy advisory firms to build in an understanding of a company’s needs for one-time compensation payments or contract provisions. For example, there was a S&P 600 specialty chemical company that received “low concern” levels on all of its pay-for-performance tests from one proxy advisory firm; however, since the company entered into a new employment agreement with one of its NEOs that automatically allowed for continued participation in a stand-alone legacy change-in-control severance agreement that included an excise tax gross-up provision, the company received an “against” vote from the proxy advisory firm. Despite the fact that the agreement was put in place to retain the executive, the company was penalized. Interestingly, a similar agreement was put in place for the same company the previous year and the company received a “for” vote on say-on-pay by the same proxy advisory firm. While excise tax gross-ups are not the market norm, penalizing a company for the continued participation in an existing change-in-control provision seems harsh, especially if it is needed to retain the executive.

On the other hand, there are some proxy advisory executive compensation guidelines that are healthy, like scrutinizing companies when excessive perquisites or multi-year guaranteed bonuses (i.e., non-performance based) are provided or utilizing the same performance metric in both the annual incentive and long-term incentive plans.

At the end of the day, there some key guiding principles that companies should adhere to in designing and administering the executive compensation program. First, companies should maintain appropriate pay-for-performance alignment, and understand whether alignment exists on a one-year and multi-year basis. Second, the board and management should understand competitive market landscape and stay away from arrangements that “pay for failure,” such as guaranteed compensation and excessive severance packages with no strict performance conditions. Third, companies should provide shareholders with clear, comprehensive proxy disclosures, which help shareholders and proxy advisory firms evaluate whether executive pay practices are reasonable.